"Do you know the only thing that gives me pleasure? It's to see my dividends coming in."
- John D. Rockefeller
While Warren Buffet, Jeff Bezos, and Bill Gates are extremely wealthy, they aren’t even close to being the richest individuals of their era. This title belongs to John D. Rockefeller, the founder and leader of the Standard Oil Company. If Rockefeller’s worth was calculated today, he would be worth four times more than Warren Buffet. How did Rockefeller gain so much wealth? Aside from controlling a massive oil monopoly, he held on to his stock and collected the generous dividends that it paid.
Although we all cannot own and run oil empires to amass gobs of wealth, we can apply the tried-and-true principles of dividend investing to help grow investment portfolios over time.
So, what should investors keep in mind when it comes to dividends? And what is the smart way to conduct dividend investing? Read on to find out what goes into a dividend payout and how shareholders can benefit over the long-term.
Dividends: An Important Sign of Growth by Companies
One of the best ways for a company to highlight their financial health and reward shareholders is to pay a dividend. Dividends are cash distributions that companies pay to shareholders from earnings. When a business pays a dividend year after year and regularly increases its dividend, it signals that the company is both profitable, growing and confident about its outlook.
Dividends have made up a substantial part of the stock market’s total return. In fact, from 1930 to 2017, 42% of the S&P 500’s return was from dividends. As the chart below illustrates, during this period spanning eight decades, dividends represented the bulk of returns in some periods while offering modest assistance in other regimes (usually in bull market decades).
What’s In Your Payout?
In my experience, the best way to measure whether a company will be able to pay a consistent and possibly increasing dividend is through the payout ratio. The ratio is calculated by dividing a company’s annual dividend per share by the earnings per share. For example, if a company pays a dividend per share of $0.50 and generates earnings per share of $1.00, the payout ratio is 50%.
A high payout ratio means that a company is using a significant amount of its earnings (and cash) to fund the dividend, which leaves them with less money to invest in future growth of the business, which rarely bodes well for shareholders. Remember as a shareholder, the company’s growth is your growth.
Surprise Dividend Cuts? What’s Uuuup With That? (Not BUD)
Knowing how to calculate this ratio can often spare an investor from the damage of a sudden and sharp reduction in income (and stock price) in one’s portfolio. With corporate earnings hitting all-time highs, a surprise dividend cut is a lot more surprising and financially painful now than it was many years ago. In fact, dividends paid in the third quarter 2018 hit a record high while dividend cuts are down 30% in the same quarter this year from a year ago1.
Recently, the largest brewer in the world, Anheuser-Busch, unexpectedly cut its dividend in half due to slowing beer sales and mounting debt. This massive dividend cut caught investors by surprise and sent the stock down 10% on the day of the announcement.
General Electric’s stock has also been in the news recently for the wrong reasons. As shown
below, GE’s payout ratio has been a source of tremendous stress in the stock. In fact, over the last three years, GE’s earnings haven’t even come close to funding the annual dividend, which has caused a mass exodus by long-time shareholders.
GE Stock Price: GEeeek! Bringing Bad Things to Light
A Healthy Payout Ratio and Dividend Growth – I’m Lovin’ It!
To illustrate how an ample dividend payout and an increasing dividend can reward shareholder value, let’s turn to fast food giant McDonald in this case. McDonald’s dividends have increased for forty-two straight years. Importantly, to fund its impressive global expansion over that time, the company has kept its payout ratio in a very comfortable 50% range. This combo meal of consistent earnings and dividend growth has certainly served shareholders over the longer-term as shown below.
How to Do Dividend Investing Like Rockefeller
There are several principles to apply with dividend investing that can ensure better outcomes for investment success over time.
- First, insulate yourself from people’s opinions about dividend investing. Many investors today are fixated on making big money shorter-term from investments with unreliable revenue streams. The disciplined and confident investor will have the patience and intestinal fortitude to follow through with the proven process of waiting and collecting dividends over time.
- Second, reliable and growing dividends come from companies with predictable revenue streams.These companies can be in industries such as spices, cell towers, animal healthcare, and as we know, fast food.GE once operated a more simple and predictable businesses. However, it ultimately chose a path of “diworsification” into long-term care insurance and oil and gas, which led to painful dividend cuts and shareholder value destruction.
- Third, reinvesting dividends to unleash the power of compounding over time can outperform many other forms of investing. As the chart below demonstrates, simply investing in those stocks in the S&P 500 that continually increased dividends year-after-year vastly outperformed other forms of investing, whether they involved dividends or not.
“You only find out who is swimming naked when the tide goes out.” – Warren Buffett
This slice of wisdom was passed on by Warren Buffett during the depths of the great recession. In a bull market and strong economy, everyone can look like a genius. However, you don’t really know or appreciate the risk behind a stock until the company is tested by adverse conditions. This is certainly the case with the sustainability of dividends and having enough dividend payout cushion.
1 S&P Dow Jones Indices, Oct 4, 2018